By: Frank Armstrong
By: Frank Armstrong
I wouldn’t touch an ETN with a ten-foot pole, and perhaps you shouldn’t either. Let me tell you why.
An ETN is not an ETF although they share the first two words and letters in their acronyms.: “Exchange Traded” and “ET.” Other than that, they are from different universes. Don’t confuse the two.
There is a lot to love about ETFs for investment advisers seeking pure market exposure at the lowest possible cost with the widest diversification in a particular part of the world’s market. They offer transparency, liquidity, efficiency, economy and they are marked to market whenever trading is open. You want the S&P 500 and you get the SPY. How about long Treasuries? The TLT is your fund.
An investor owns his little share of a market basket of stocks in a registered, regulated, segregated, audited, standardized instrument. Just like the open end mutual funds we are all familiar with, should the sponsoring company fail, the assets are protected in the separate account and not subject to claims of the sponsoring company’s creditors. In many of the world’s most liquid markets, they are the best game in town. What’s not to like?
With all the above advantages, ETFs have rightly rapidly gained wide acceptance. Well known issuers include iShares, Vanguard, Schwab, Fidelity, Powershares, Northern Trust, Russell, Wisdom Tree, and First Trust to name a few.
With the evolution and acceptance of ETFs have come evolutions like leveraged, inverse, and managed ETFs. As purely passive investors, my enthusiasm for these issues is virtually nil. It’s still and always necessary to pick and choose investments that meet your particular needs and criteria.
An exchange traded note (ETN), on the other hand, is simply an IOU from a bank, more correctly a hedge fund formerly known as a bank. The investor doesn’t own anything. There is no segregated account of assets. There is no structure or firewall between the IOU and the issuer’s general assets. The investor is just an unsecured creditor of the bank.
The ETN is not a registered security. Even if it’s issued by a bank, it’s not insured by the FDIC as a deposit or CD might be. It’s a derivative whose value is loosely determined by changes in an index less fees.
That was enough for us at Investor Solutions. As a fiduciary, we have a prime obligation to diversify away any risk we can. Being an unsecured creditor of a bank is a giant undiversified credit risk on a single entity. So, we crossed them off our list and pretty much forgot about them. Given our later experience in 2008 and 2009 that policy stood us well.
Today there is not a bank or brokerage in the universe whose credit I would trust. You know that they remain undercapitalized and subject to the same downside financial and moral risks we enjoyed in 2008 and 2009. Remember those fun days when even small businesses were jumping through hoops to break up their deposits into FDIC insured chunks? Would you like to bet the farm that it couldn’t happen again? Not me!
If you don’t think it can happen, just ask holders of EOH Opta Lehman Agriculture Pure Beta ETN, PPE Opta S&P Private Equity Notes 2038 ETN, and RAW Opte Lehman Commodity Index ETN how they liked the Lehman Brothers Ride. Those three funds were listed by Lehman on February 20, 2008. The rest, as they say, is history. When Barclays acquired some of the trading assets from Lehman, they specifically disavowed responsibility for the ETNs. Trading was suspended and the funds delisted.
I take some comfort in regulated securities that have elementary checks and balances and structures designed to protect investors. ETFs are regulated, have boards of directors, auditors and a fairly straightforward and standardized structure.
ETNs are individually drafted, unregulated IOUs designed by organizations with murky financials and proven track record of unscrupulous behavior. Given their highly complex offerings and non standard structures, a sophisticated issuer has plenty of opportunities to enhance their offering at your expense. Not surprisingly, some do.
Given that an ETN is actually a badly needed contribution to the bank’s capital it’s particularly annoying to find one of them gouging the investor on fees.
Almost all asset classes that are offered as ETNs can be found as ETFs. A very few ETNs in alternative asset classes may claim better tax treatment than a ETF, but we find that most investors could hide a less tax efficient structure inside their qualified plans or IRS to negate any tax advantage the ETN might claim.
I suppose if you were the one person on the planet that understood big bank balance sheets, and if you cared to track their financial condition on a second by second basis, you might want to consider an ETN. No matter how attractive the marketing literature, we are not buying into any unregulated security or undiversified credit risk.